Earlier this week, Timothy Geithner unveiled his plan to rehabilitate the banking system. The program, in summary, is more than forty pages in length and contains proposal to deal with both bad loans and toxic mortgage backed securities. It addresses many of the concerns that have been voiced about further government intervention but is still lacking on a few key points.
One of tenets of Geithner’s proposal is the investment of private equity (alongside equal government equity) with leverage provided by an FDIC-backed program. While we applaud Mr. Geithner for what appears to be a reasonable attempt to ensure the rationale pricing of assets, as the government will not be responsible for pricing them, and reasonably sharing of any upside, as the government will participate equally in the equity, we can’t help but point out two major issues with the program.
The first problem has to do with the ability of the general public to invest in the programs. Taking a cynical view, the act of providing 6x leverage at 5% below prevailing market rates represents a direct transfer of wealth from future taxpayers and/or current holders of USD wealth to private banking institutions who currently own these assets.
To put this in perspective, let’s look at a simple example. If the financing is truly 5% below market rates and at a fixed rate, the economic giveaway is truly staggering. Let us look at a $3,500bn pool of 10 year assets with $500m in equity capital. Assuming a 10% required return on the equity, the discount financing would represent a value of $921m assuming that interest rates remain at their current, historically low levels. The value would grow as interest rates rise (which seems likely), providing an embedded option in the financing as most of the purchased assets are variable rate and the market rates can’t fall much further.
If the above is true and there is a differential between the market rates and the rates provided by the government, this financing is clearly nothing more than an under the radar transfer of economic value. The benefits of this subsidy will be priced into whatever the private capital is willing to pay for the assets. While it will not be fully priced in, you can bet it will be partially represented in the market clearing valuations. When the transaction closes, the risk will transfer to the government in the form of underpriced risk and the money to the troubled banks in the form of cash. One can reasonably ask if the government wouldn’t be better off making a direct control equity investment rather than this bad trade.
The second problem is the limitations the program places on who is able to participate. While we would have less of a problem with this transfer of wealth if everyone were aloud to participate in the benefits, it seems to this writer that significant barriers have been put in place to prevent the general public from participating in what could be a huge economic giveaway. The program places multiple limitations on participants including:
- Minimum contributed capital of at least $500m of private capital;
- Demonstrated experience investing in Eligible Assets, including through performance track record (unlikely anyone in these assets has a good track record);
- A minimum $10 billion (market value) of Eligible Assets under management;
While we agree that strong anchor investors are necessary for the program to work, we don’t understand why the general public can’t participate to both ensure that the prices are fair and that any pure giveaway in interest rate differential can be shared among all investors, regardless of size. To address this point, why not set up a program much like the Treasury Direct program whereby smaller investors can bid, on a non-competitive basis, to participate in any asset purchase that is backed by FDIC guaranteed money. Individuals in this country are sitting on large sums of money and it would seem that the more participation these programs can get from a broad cross section of investors the more successful they will be.
